Oil and Gas Prospect Quality: Problem or Opportunity?

Abstract: While large independents identify a decline in prospect quality, other oil and gas firms still see opportunity.

Analysis: The prospect for prospects? There are plenty out there -- just ask Oil and Gas Advisory readers.

The real challenge over the prospect issue is a particular mindset these days regarding the way the oil and gas industry approaches hydrocarbons. The emphasis is on acquisition and exploitation, as financial pressures force publicly held companies to focus on equity market valuations. Basically, the industry is pursuing a harvest strategy -- one reader calls it a "salvage operation" -- rather than applying financial resources to higher risk exploration targets whose true payoff would be sometime in the future.

The other problem is capital availability. Drilling would move forward on a variety of attractive targets, even at commodity prices well below where they are currently -- if capital was available.

The prospect issue has worked its way into oil and gas conversations over the last year. Today, the "lack of quality prospects" issue is among the more common items cited as a reason drilling levels remain low despite high commodity prices. This is, after all, the first time in the last 100 years that high prices have not generated expanded field activity. Such disconnects are rare in oil and gas. It is possible to trace the "lack of quality prospects" idea back a couple of years to presentations made to the investment community by a handful of large independents. Certainly, management at Anadarko played an indirect role by pointing to the maturing nature of prospects in the North American natural gas market. In its investor presentations, Anadarko used the term "basin exhaustion" to describe the trend.

The company illustrated the concept with a theoretical S-curve profile that describes the history of cumulative reserves. Reserves are slow to grow during the learning phase of exploration, but take a giant leap upwards as new knowledge leads to big field discoveries. Eventually that curve flattens as the rule of diminishing returns comes into play -- the ultimate arc resembling a distended version of the alphabet letter "S."

Anadarko cited the Gulf of Mexico as an example. Over the 60-year period ending in 1997, more than half of the cumulative reserves were generated in the first 250 discoveries. The next 250 discoveries moved cumulative reserves above the 80-percent level. The next 600 discoveries accounted for the final 20 percent of total cumulative reserves in a flattening arc.

The theory is applicable to North America. Natural gas production is decreasing in a central core region dominated by Texas and an arc of states from Kansas southeast to Mississippi. Natural gas production is increasing in outlying areas from the original core, including the Rockies -- particularly Wyoming, California, and western and frontier areas of Canada.

Similarly, EOG Resources has popularized a rainbow-colored slide showing natural gas decline curves by year of discovery. The more recent the well, the greater the decline. That slide, possibly the most ubiquitous fixture in industry presentations these days, illustrates an accelerating depletion curve in the U.S, but is also descriptive of new Canadian production. The basic theory is that the industry must run faster just to stay in the same place.

While the large independents speak openly of the prospect issue, it is a different story elsewhere, as Oil and Gas Advisory readers point out. The prospect issue is, in part, a question of semantics. As one reader noted, if a prospect is defined as a reservoir that is inexpensive to develop and produce, located near existing transportation infrastructure with established access to premium markets, then there are indeed fewer prospects available today. But if prospects are defined as any zone capable of producing hydrocarbons regardless of cost, targets are plentiful.

Another reader wrote, "We are a small independent generating and developing prospects in South Texas, the Midcontinent, and the Rocky Mountains. We are able to come up with small prospects that are economic for us to pursue. But I sense there is a lack of larger reserve prospects that make more sense for the larger independents and the major companies."

The key phrase here is "lack of larger reserve prospects. " One Wyoming-based reader noted that oil and gas prospects were shrinking in size and growing in risk. It has been six years since the last major discovery in the Rockies, the reader wrote, despite an aggressive drilling campaign. A South Texas independent explained that his firm laid a rig down for the first time in half a decade after their aggressive deep drilling gas program ran short of quality prospects.

However, the problem is not necessarily with the resource. Readers pointed to a cultural change over the last decade as industry management evolved from a risk-taking group to a risk-averse business. Readers identified modern corporate mindsets that were focused solely on acquisition and exploitation. Some wrote to say they generated prospects and approached large independents whose technical staffs approved the programs, but the projects died when general management proved reluctant to risk money drilling based on an idea generated outside the company.

Others noted that unless a prospect is accompanied by 3D seismic images, many independent exploration and production companies will not even look at the deal. "A good oil and gas prospect does not necessarily need 3D to make it valid," the correspondent noted. "Most successful geophysicists will agree that good 2D data properly processed is valid, and 3D can sometimes cost as much as the first four wells in a prospect. Why not just drill a well?"

Many readers pointed to the legacy of industry layoffs over the last 15 years. "It is my opinion that there are numerous Grade A prospects in company files on land held by production that will never be drilled because no one still with the company is aware of their existence," notes a reader.

Other Oil and Gas Advisory readers alluded to an array of low-cost shallow prospects that could generate double-digit returns on capital but are ignored by firms who need reserves of 20 mmbbls or more to make a project worthwhile.

And that speaks directly to the issue. Ultimately the phrase, "lack of quality prospects, " is code describing an evolutionary process in a maturing industry.

The majors used the term 10 years ago before divesting U.S. properties and heading overseas. Independents bought those properties, then merged, acquired, drilled, or purchased their way into becoming super-sized firms. Now those firms are unable to generate adequate return on investment simply because of their critical mass. The rise of the large independent has been a wonderful success story over the last decade. But the process is maturing. These companies have grown so large that they, too, are forced to follow the majors to deepwater offshore, or overseas.

Ultimately, this will lead to another round of divestitures and a period of turmoil while the oil and gas industry restructures and smaller firms, more nimble than their larger counterparts, begin reassembling properties and milking the remaining hydrocarbons from them.

The process is beginning. Oil and Gas Advisory readers itemized several examples in which smaller, privately held oil and gas companies have been acquiring leases from larger independents that can no longer afford to produce them and whose technical people could not convince their management to drill the smaller prospects.

It turns out that a prospect, like beauty, is defined in the eye of the beholder.